Why Global Financial Markets Are Going Crazy

Last week, global financial markets were churning, but it really only mattered if you were an oil trader, Chinese bureaucrat or hedge fund manager.

Now it’s starting to get scary for everyone.

An 8.5 percent drop in the Shanghai Composite index in Monday’s trading session spread to financial markets across the world. In the United States, the broad Standard & Poor’s 500 index was down 2.5 percent in Monday morning trading, after steeper declines in Asian and European stock markets, falling prices for oil and other commodities, and a rush of money into the safety of United States Treasury bonds.

What’s fascinating is that there is no clear, simple story about what is different about the outlook for United States and European corporate profits; interest rates; or economic growth compared with one week ago, when the S.&P. 500 index was 8 percent higher.

Here’s how to make sense of what is a truly global story, stretching from the streets of Shanghai, where stock investing has become a middle class sport in recent years, to the oil fields of both the Middle East and Middle America, to the hallways of power in the Federal Reserve in Washington.

This Started in China, but Is a Lot Bigger Than China

The immediate trigger to the outburst of global volatility was China, where the sharp drop in stocks Monday continued a rout that has been underway — with periodic pauses thanks to government interventions — all summer.

The Chinese economy is slowing, and the 38 percent drop in the Shanghai Composite Index since June 12 is indeed a huge number. There is no question that this giant economy is struggling with a transition from the investment-and-export-led boom of the last generation toward something more sustainable.

But a few facts make China’s problems less satisfying as an explanation for the turmoil across world markets. The Chinese stock market has risen sharply over the past year as millions of middle-class Chinese citizens took to making investments. Even after its steep drop this summer, the Shanghai index is down less than 1 percent for the year and still up 43 percent from one year ago.

There may be a more complex story for why a sharp drop in the Chinese market should cause bigger ripples in the global economy than the sharp gain over the six months that preceded it. The fact that the Chinese government has pulled out unprecedented steps to try to contain the stock market sell-off, to little avail, may suggest limitations on the power of even the mighty Chinese state.

In other words, the sell-off in Chinese stocks may not matter much in isolation. But it tells us much about the inability of Chinese leaders to bring its economy in for a soft landing. And that is something scarier.

Other Emerging Markets Are Getting Hammered

Some of the key evidence for the “this is about more than China” story come from other emerging markets, stretching from Malaysia to Mexico, that are also taking it on the chin. Their currencies, stock and bond prices have fallen sharply over the last week. Some of that most likely reflects exposure to the Chinese economy. But some of it reflects something bigger.

Call this the Taper Tantrum 3.0.

The original taper tantrum happened in June 2013. It is a cute name for what happened when global financial markets collectively went berserk over the realization that the Fed was serious about tapering its program of quantitative easing — or for regular folks, that the Fed would wind down its injections of money into the financial system over time.

In effect, the Fed’s easy money policies led global investors to search for higher-yielding securities, which they found in many faster-growing emerging markets. Money gushed into these countries in search of better returns from 2010 until 2013, driving up prices of assets.

But as the end of the era of cheap dollars has approached, that hot money has pulled out — and created volatile spikes in interest rates and damage to those emerging economies. (Look at this presentation by Hyun Sung Shin of the Bank for International Settlements for a more detailed argument around how and why this happens).

Falling Oil Prices Are a Cause and Effect

The carnage in financial markets has had a particularly big impact of the price of commodities, including oil, the most economically significant commodity of them all.

The price of a barrel of oil fell from around $60 in late June to under $40 on Monday. Over time, that will be good news for American and European energy consumers, but there are complex feedback loops that probably make the commodity sell-off both a cause and a result of the broader emerging markets panic.

When oil prices first plummeted in the second half of last year, there were widespread forecasts that the price drop would cause oil exploration to shutter around the world, helping keep the market in balance. Instead, American producers have kept up production, keeping supplies high despite lower prices.

Here’s the feedback loop: The slowdown in China and other emerging markets lowers demand. High supplies and weak demand equals lower prices — which feeds back into weaker economic conditions for energy-producing countries like those in the Middle East, Latin America and Russia.

Then the Fed Makes Its Move

In the background of all of this is a crucial decision looming for the United States Federal Reserve. Fed officials have expressed confidence that the domestic economy is on track and that the time is right to raise interest rates after nearly seven years of keeping them near zero. It could make that move at its policy meeting Sept. 16 and 17.

Fed officials have indicated a determination to base interest rates on what is most appropriate given the state of the American economy and not to overreact to fluctuations in markets. The latest volatility will test that resolve.

Futures markets are increasingly betting that the Fed will indeed hold off to assess the damage to the economy, if any, from the latest global financial strains. On Monday, the market priced in a 24 percent chance of a rate increase in September, compared with a 48 percent chance just a week ago.

And the value of the dollar on currency markets fell 1.6 percent Monday (as measured by the dollar index) as investors priced in greater likelihood of the Fed’s keeping rates lower for longer.

Commentators have long accused that the Fed of overreacting to the latest financial market moves, a complaint that makes Fed officials bristle; they argue they are making their decisions based on measures of the real economy like inflation and employment data. If markets remain volatile heading into the next meeting but economic data remains consistent with recent solid readings, that will make for a tough decision.

Of course, it is the Fed’s job to set policy based on where the economy is going, not where it has been. If markets keep falling, that could endanger American growth prospects. On the other hand, the Fed’s job isn’t to try to protect investors from the risks of a downturn.

And if the last few days have taught anything, it is that global markets will be poised for a big reaction, no matter what the central bank does.

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Welcome to Views From The Lake. We believe in providing the public with transparency and giving them a platform for open communication. So we created this blog to provide you with timely market information as well as relevant financial news and economic updates. Please make sure you visit this blog often to be kept up to date on our many discussions.